The Bank of England finally agrees with me (three years too late for the UK economy)

The last 24 hours have seen something of a sea change in the way that Quantitative Easing (QE) is being regarded by at least some in the world’s central banks and it is this that I will discuss today. This has come as a counterpoint to what has been described as “QE (to)infinity£ where the US Federal Reserve stated that it would keep applying the medicine until the US unemployment rate dropped to 6.5% assuming inflation stayed below 2.5%. It is also in stark contrast to Japan where her new government is applying ever more pressure on the Bank of Japan -already on QE11- to do ever more. Although the Yen is doing some of the job for them as it has dropped to over 88 Yen per US Dollar as I type this.

The Bank of England takes over 3 years to agree with me

Back in the early days of my blogging career I pointed out this in December 2009.

My belief is that the UK economy has shown a type of inflation inelasticity which has surprised virtually everyone and there is more to this than just QE. In the UK Gross Domestic Product has fallen from its peak by 6% and yet inflation is only 0.1% below its target. As we move into 2010 our inflation rate will exceed its target in the early months of the year.

So my opinion was that the UK had an inflation problem which QE was making worse. Our economy had then -and of course has continued to have – an inflation rate which is not only above its official target but also higher than our economic performance would suggest. A clear impact of this on our economy has been that this higher inflation combined with low increases in wages has meant that inflation has directly led to further economic weakness as it has caused the level of real wages to fall. We have found ourselves trapped in the opposite of a virtuous circle.

Step forwards to January 2013

The Bank of England has issued Discussion Paper 38

In the conclusion we are told this.

For instance, ignoring cross-sectional dependence would lead a researcher to believe mistakenly that recent weak UK output growth was entirely due to demand rather than permanent productivity shocks.

This matters because it has been Bank of England which has been arguing that UK “weak UK output growth was entirely due to demand” via the so-called output gap theory that I have been criticising for the past three years. So in my financial lexicon “a researcher” is now a euphemism for the whole UK Monetary Policy Committee.

This discussion paper also argues this and the emphasis is mine.

The previous conclusions are now clearly overturned. Both permanent labour productivity and temporary demand shocks now contribute roughly equal amounts to recent (2010 and 2011) weak output growth in the UK.

Let me now explain why this matters. Previously the Bank of England view was that UK output was way below capacity (with estimates varying but up to 14% of our Gross Domestic Product) and so boosts to the economy would have little or no effect on inflation. In textbooks this is often covered under demand pull inflation. However my argument was partly based on the fact that up until the credit crunch we were overvaluing our GDP in some areas and accordingly (sadly) some of it no longer existed and so any gap was much smaller than argued elsewhere . For example take a look at the UK’s banking sector. If it was not valued way over reality in 2007 why was so much direct support (Lloyds TSB,RBS,Northern Rock,Bradford and Bingley etc) and indeed indirect support such as QE,Supplementary Lending Scheme, base rate cut to 0.5% and now Funding for Lending provided? Oh and the backstop provided by the “Too Big To Fail” put option provided by our politicians with taxpayers financial backing.

Following this type of analysis also explains why we might also be measuring productivity changes incorrectly but I will leave a full discussion of that for another post.

Institutionalised Inflation

Another factor in the UK’s problems with inflation has been what I have labelled institutionalised inflation. This is where UK government and organisations in or attached to the public-sector regularly raise prices at above inflation rates. We have seen this for example in the surge in prices the Royal Mail charges for a postage stamp or this week in the increases in train fares where I am suspicious of the “4.2% increase average” claimed. Even if we take the rail fares increase at face value it is double the official inflation target.

If I had been appointed onto the UK Monetary Policy Committee I would have used the role to argue against such increases. As they are mostly not something you can deal with by raising interest rates. I notice that the current MPC is virtually silent on this issue apaprt from sometimes using it as an excuse. As controlling inflation is supposed to be their job they should be addressing this and looking for and using new weapons rather than passively whining.

Today’s data contradicts what the Bank of England told us only yesterday

Yesterday I pointed out that the Bank of England was slapping itself on the back about its Funding for Lending Scheme in its credit conditons report. Today we have some actual numbers to peruse. Let us remind ourselves of what we were told.

The availability of secured credit to households was reported to have increased significantly in the three months to mid-December 2012…. Demand for secured lending for house purchase was reported to have increased in Q4

So supply and demand were up which leaves them with something to explain about their own statistics.

Within total lending, lending secured on dwellings fell by £0.2 billion, compared to the previous six-month average increase of £0.3 billion.

Is up the new down?

In the detail I think that these mortgage growth numbers are as weak as they have been.

The three-month annualised growth rate was unchanged at 0.1% and the twelve-month growth rate was 0.6%

The US Central Bank has worries too

Last night the latest minutes were released by the US Federal Reserve and if we consider that this was the meeting where QE to infinity was enacted they came with something of a surprise.

Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet. One member viewed any additional purchases as unwarranted.

So not quite to infinity then? These individuals are likely to (wisely) have concerns over exactly how any exit strategy will be applied to an ever growing amount of QE. However some caution is needed about this becoming policy as non-voting members are currently more hawkish than the voting ones.

Comment

The Bank of England appears to be taking the path of using a discussion paper as a hint of a change in the official view on QE, a bit like a weather vane. Later perhaps we will see such views reflected in official speeches by a type of osmosis. If we “step back in time” three years we see that some members of the MPC were diometrically opposed to the idea that QE was inflationary.

One rather curious intervention by Adam Posen has been to claim that the mechanism espoused on the Bank of England’s website of QE influencing the money supply and then inflation does not work.

Frankly the Bank of England has had a very poor credit crunch and todays figures which directly contradict what its credit conditions report told us only yesterday is another nail in the coffin of its credibility. Also with Gilt yields continuing their recent rise (the ten-year yield is now 2.12%) the most recent tranche of QE is all at a loss which is food for thought for those who want to spend the “profits” and also for those who keep telling us that bond yields will stay low for ever.

However for the future for QE some care is needed. You see when push comes to shove I expect central bankers to revert to type and give us “More,more,more” after first parading their consciences. Or as newt put it in the film Aliens.

Shaun, this is consistent with the OBR’s view that the output gap is much smaller than it appears and UK GDP is actually adjusting to a permanently lower trend. Which is worrying, because it suggests that there will be persistent underemployment (disguised unemployment) and nominal wage depression. Lots of people disagree with the OBR, though.

I really can’t see inflation as the main issue – particularly since CPI doesn’t include most forms of retailers’ discounting (of which they are doing HUGE amounts) but it includes government tax changes such as VAT rises and tuition fees. It’s a very flawed measure which simply does not show the underlying deflationary trend in the real economy.

I agree with you about interest rates not being an appropriate tool to manage above-inflation rises by “protected” industries. Government should simply refuse to allow those rises. Why are the industry regulators saying nothing?

I also agree that QE is toxic and has been for quite some time. The first round I think had some positive effects in propping up asset prices Fisher-style when the economy was going into a debt deflation spiral. But since then its effects have been contractionary for the real economy due to widening credit spreads and restriction of spending by those on fixed incomes. When banks aren’t lending (for whatever reason), QE is monetary tightening, not easing.

pavlaki

Excellent! I only hope you are wrong about yet more QE but I suspect that’s exactly what we will get. The other side of QE is the drop in the value of Sterling which causes significant imported inflation. Sterling’s drop is always quoted as good for the economy as it helps exports and yet if one looks back at export performance GB Ltd was doing rather well at Euro 1.45 to £1 and there doesn’t appear to be a lot of evidence that lower Sterling is helping a great deal. My experience in the Euro zone is that the crisis has caused a drop in demand for goods ‘at any price’ and so a lower Sterling makes little difference. It makes imports into the UK a lot more expensive though! I wonder to what extent this is factored in by the MPC?

Ian

Interest is supposed to represent the return for risk, the risk in the last few years has been sky high yet interest rates have been forced to zero. Existing debtors are bailed out but very little new debt is made available as the interest rate is below the rate of return for the risk so the economy freezes up.

End game is QE to infinity with large rises in inflation to wipe out the debt. Ultimately either asset prices fall or the general price level rises and since asset prices are being supported by QE its obvious what the policy really is.

James

Shaun,
As interesting as ever. I would comment that, for politicians, QE has been just fantastic, as:
1. No member of the press, let alone the public, has the faintest idea what it is, but the politicians can claim credit for “doing something”
2. It drives interest rates down, which helps the deficit
3. It creates an illusion of demand for gilts
4. It props up the stock market, as investors have to invest in something
5. It props up house prices by lowering interest rates
6. It doesn’t do nasty things which people might notice, like raising taxes or imposing “more” cuts
7. No-one is asking how it could be reversed
8. Inflation is a “bit annoying”, but not like losing your job/house etc, especially if you have an index-linked pension like MPs, governor of the bank of England etc.
9 It takes the pressure of having to something real about the deficit
The political dialogue is almost entirely about:
1. the “cuts”. I notice that no-one challenged the Labour discussion today about the welfare rises being limited to 1% when they just discussed “redundant nurses”as though this was where the majority of benefits goes.
2. Specific inflation (rail fares, energy bills) but not general inflation or the fiddling of the figures
3. House prices
4. Child benefit cuts for those on more than £50k
The common feature in this dialogue is that journalists and the public only get exercised when something very specific and tangible happens. QE never makes it to that point so never gets discussed.
When I become dictator, every TV and radio programme will start off with a feature stating that:
1. The government borrowed £10 each since yesterday
2. It is now spending so much more than it taxes that the whole of the NHS is funded by borrowing
3. The government has hidden £375 billion of this borrowing by fraudulently inventing money through QE, which has been spent but appears nowhere as borrowing
Perhaps then the dialogue will become a little more balanced!!

Pavlaki

Good comment, totally agree!

MajorFrustration

Shaun – change your name to Tony Saprano and perhaps your message may get through to these political/economic/financial mut thickos. Just and idea. Make em an offer. Its not just the BoE that has had a poor credit crunch its also the poor British Public thats had a pathetic central bank

Drf

“However for the future for QE some care is needed. You see when push
comes to shove I expect central bankers to revert to type and give us
“More,more,more” after first parading their consciences.” Of course Shaun, since the real reason for continuing will be the same as the original one for commencing this idiocy; to generate inflation to pay for the political profligacy instead of raising taxes, which loses votes!

DaveS

They can use any academic nonsense they want to justify QE. Did anybody ever believe the ridiculous output gap theory stuff ?

Bottom line is that the Government deficit is out of control. Government spending exploded under Brown using the proceeds of “growth” – i.e. the proceeds of a fake economy pumped up on credit steroids. Now the credit bubble has burst they can’t cut spending – its electoral suicide and it would tank the fake economy even further. Catch 22.

So Mervyn has to monetise – if he doesn’t, Gilt rates spiral upwards, housing market crashes, country heads inexorably towards hard default. I suspect Gilt yields have been drifting upwards because Mervyn has been busy changing the printer ink. The newspapers are trailing bad news today on the service sector so cue Mervyn to come to the QE rescue again. I wouldn’t recommend shorting Gilts.

The BoE is just a propaganda outlet.

JW

Because its called the Bank of England doesn’t mean it works for England, it works for commercial banks and always has done.

JW

Hi Shaun

As usual it was Lacker who voted ‘no’ at the Fed, I suspect ‘several’ meant ‘two’, one other joined him. Doubt it will stop the Fed performing their lead role in the grand vampire squid plan for fiat diminishing value. Also doubt the BoE wont fail to perform their supporting role.

BoE like all CBs support the commercial banks, they dont support the ‘nation’. Clearly part of this role is to protect the ongoing financialisation of the economy. QE , in monetising debt, has done what was intended, more will have to follow, indeed QE ‘infinity’ looks inevitable. If it leads to more inflation then that is an added bonus to the government but just like ‘growth’ , that is just a side effect.

Anonymous

Hi Francis

As you know the inflationary issue is a concern to me but is also one where I have argued for reforms to make it more realistic. For example the move to CPI in 2002/03 then left us with no asset or house price measure in our official target for inflation just as they hopefully would have been useful!

Sadly my suggestion that a type of house price measure should be used was ignored and we will use rental equivalence in what is now called CPIH. This according to the data provided by the Royal Statistical Society would have been useless in helping us in the last decade.

My point here is that house prices could easily be a deflationary influence in times ahead when rents show an inflationary one… Oh what a tangled web and all that!

Anonymous

Hi pavlaki

You take me back to discussions I have had with drf who has followed this issue since my blog began. I feel that rather than the continuous line of economics textbooks extra orders come in erratic patterns if you have a fall in the £ so it is possible to have some drops with no extra orders at all or very little. Also as you say the background environment can change.

However more recently £ has rallied against the US $ from the US$1.53 lows of early summer and strongly against the Yen from the low/mid 120s to 141 which is not often remarked upon.

Anonymous

Hi Ian

Many interest rates are at the wrong level with some too low but others are too high (for example credit card rates have barely changed as base rates have plummeted). In short ZIRP exists in wholesale markets but has only reached some of the retail markets and this is partly why it has not worked.

Anonymous

Hi Major
I did enjoy the Soprano’s TV series which was well written and made but wasn’t it Marlon Brando as the Godfather who originally suggested “make them an offer they cannot refuse” with its obvious dark undertones.?

Anonymous

Hi Dave

More than a few few economists seemed to swallow it!

Anonymous

Hi JW

In “Fed speak” then several means maybe up to five, but if we put the “Three Dissenters” of last year into that camp as seems likely it does not take us very far. As they do not currently have a vote then Mr. Bernanke has what looks like a comfortable majority.

The next move in the global game of chess is likely to come in Japan but as they review 88 Yen versus the US $ and 115 Yen versus the Euro and 141 versus the £ they probably think that things are going rather well….

Anonymous

Good comment. Speaking of challenging Labour – they need to start justifying all their “investment” in public services and how it has supposedly helped the UK

Anonymous

In my day there were economic textbooks that said a fall in real wages was required to bring about full employment. There probably still are.

Shaun Richards is an independent economist who studied originally at the LSE. His speciality is monetary economics and he uses it to analyse current economic trends. He started his career in the City of London in 1985 and brings his trading experience in bond, currency and derivative markets to his analysis of current economic events. Follow him on twitter @notayesmansecon.